Getting My Geek On

I have said before that I am something of a geek. In addition to reading news, SEC filings and anything else I can get my hands on, I am fond of academic studies on the markets. I'm among a small group that passes these studies around like baseball cards, looking for an edge or additional tool to help us succeed. I skim a lot of them and throw them away because so much academic research is the result of a "publish or perish" mentality, which tends to produce faulty work with erroneous conclusions by authors writing for tenure and not for financial gain. A few, however, produce exploitable ideas that can make me a better investor.

I like was the work of recently deceased pioneer quantitative investor Robert Haugen. Along with Nardin Baker of Guggenheim Investments, he published a study entitled "Low Risk Stocks Outperform within All Observable Markets of the World." The paper was a follow-up to earlier work by the two that showed higher risk did not necessarily equal higher reward. This study applied the principle of buying less volatile stock to 33 different markets around the world between 1990 and 2011.

The paper flies in the face of a traditional Wall Street theory that the higher the risk, the higher the reward. Haugen and Baker say that widely held belief is the reason low-volatility stocks outperform their high-flying, riskier brethren. Money managers are taught efficient market theories and the capital asset pricing model in school and, as a result, tend to embrace higher-risk stocks to chase higher returns. Most managers tend to favor stocks with the most analyst coverage and media attention, and these are the most volatile issues on the stock market. According to the study, it is exactly the wrong way to approach portfolio management.

This is a potentially important study with amazing implications, so I ran some numbers and set up a screen for the most- and least-volatile stocks on the S&P 500 to see if I could draw my own conclusions. I am not a grand mathematician or statistical genius, so I drew my screens using simple measures like beta and monthly volatility, which are easy to find and calculate.

The riskiest stocks in the index to be avoided, according to the study, include some current darlings of traders and investors alike. Netflix (NFLX) has taken shareholders on a wild ride over the past year and is one of the most volatile stocks in the index. Investors have made good money in Tesoro (TSO) over the past few years, but this study suggests it is too risky to own for the long-term investor. Fossil (FOSL) has recovered some from its earnings-related price dump earlier this year, but the shares are still on the too-volatile-to-own list. I was disappointed to see that Micron Technology (MU), one of my holdings, made the list of no-no stocks.

On the other end of the spectrum, the lowest-volatility names in the index produced stocks that you do not hear discussed much on TV. The list contains all the typical lower-risk consumer-products companies, like Procter & Gamble (PG), Heinz (HNZ) and Kellogg (K). Drug companies such as Bristol-Meyers (BMY) and Johnson & Johnson (JNJ) also made the list of low-volatility, under-owned issues that should outperform their more popular brethren in the index. Tobacco may not be a popular industry, but Reynolds American (RAI) and Altria (MO) are on the list of potential lower-risk winners. One real bonus to this approach to viewing the markets is that all the low-volatility stocks tend to pay relatively high dividend yields.

The research by Haugen and Baker ties in nicely with one of my favorite questions for investors and traders: Why are you doing what every else is and expecting better results? Traders flock to stock like Apple (AAPL), with almost three times the market's volatility. Now that the stock has risen sharply, Bank of America (BAC) has become a market favorite, despite the fact that volatility is actually greater than the index by a factor of more than three. Market participants tend to focus on the same sectors and subsets, with higher volatility and lower returns as a result. The evidence suggests that the opposite approach would be less popular but more profitable.

On Friday, I'll take the paper's conclusions and combine them with my own valuation tools to see if I can produce a winning approach to buying low-risk stocks.

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